With the herd-like instinct for which they are renowned, more than 15,000 of the world's media representatives have descended on Denver this week for the Obamafest that is this year's Democratic National Convention.

This ought to worry thoughtful people everywhere because it almost certainly means that the big story this week will be happening elsewhere.

Certainly, as far as financial markets are concerned, events this week in an almost deserted and ignored Washington might well have more significance and will probably be more dramatic than the choreographed exercise in hagiography out in Denver.

It is back in the US capital that decisions have to be made imminently to end the dangerous farce that has been unfolding over the future of Fannie Mae and Freddie Mac.

These two ugly siblings, you'll recall, are odd hybrids - shareholder-owned companies whose senior management is appointed by the Government and who have an uncertain relationship with the taxpayer. They buy bundles of mortgages from banks and either keep the securities on their books or sell them on to others, essentially guaranteeing that the principal and interest will be repaid.

In the past decade they have mushroomed and now guarantee almost half the total outstanding $11 trillion (£6,000 billion) in US mortgages.

With house prices falling and defaults rising, the value of these mortgage-backed assets is declining rapidly - but Fannie and Freddie must still pay up even if the value of the securities dwindles to nothing.

So they are seriously under water. Last month, Hank Paulson, the Treasury Secretary, tried to pull a clever trick by announcing that he stood ready to provide them with the money needed for rescue if they failed. But the idea was that, by announcing such putative support, the Treasury would get away without having to do so. The knowledge alone that the US Government stood behind the two financial institutions would ensure that they would be able to tap private sources for the additional capital they needed.

No such luck. Fannie and Freddie renewed their downward plunge during the past week: the Government's bluff is about to be called.

Fannie and Freddie are not just vast institutions in themselves: their troubles are having a domino effect throughout the financial system. Hundreds of banks hold the institutions' debt - some of which was downgraded last week to just above junk bond status.

And so a rescue seems inevitable now. Yet even if the Treasury moves quickly, the signs are that the intermeshed housing and financial crises are once again threatening a broader economic calamity.

The fragile state of the US financial system was the main topic of discussion at last weekend's Jackson Hole monetary symposium, attended by the leading Federal Reserve officials as well as central bankers from around the world.

Much attention was given to remarks by Ben Bernanke, the Fed Chairman, which suggested that the central bank would keep interest rates low for now as the inflation picture promised to improve thanks to softer commodity prices and a stronger dollar.

While his critics once again fulminated that he was missing the inflation threat, the bigger story was that the Fed was also signalling that it remained nervous about the weakness of the US economy. So far, the financial mess that has unfolded over the past year has not done too much damage to the so-called real economy, but the risk is rising that, as the financial crisis continues, the broader economy - people's jobs and incomes - will start to suffer.

The fundamental problem is that house prices continue to fall and with them the value of the mortgage-backed securities that sit on the balance sheets of so many lenders.

Just last weekend the authorities had to rescue yet another bank - a small one unheard-of outside Topeka, Kansas, admittedly, but it was the ninth failure this year.

More shivers will travel down bankers' spines today when the Government releases an updated list of banks in trouble. Meanwhile, Wall Street continues to buzz with rumours about the perhaps imminent end of Lehman Brothers, the once-proud but increasingly desolate investment bank, as an independent institution.

What makes the financial problems so threatening now is that banks are caught in a vicious downward spiral. They are required to maintain shareholder capital at a certain proportion of their risk-weighted assets. But they are now in a double-bind.

The value of their capital is shrinking, forcing them to cut their assets (ie, for the most part, loans). Meanwhile, the volatility in financial and housing markets is increasing the riskiness of the assets that they already hold - so that is also forcing them to cut back on lending to maintain even plausibly healthy balance sheets.

There is a growing sense among policymakers that the only way to end this spiral is for the taxpayer to step in and prop up the financial system with large injections of cash.

Last week, John Lipsky, the No2 at the International Monetary Fund and a widely respected former Wall Street economist, [said] it was “plausible that there has been a recession in the US” and that any recovery would be gradual and tied to the ability of the financial system to work through its present problems. And, he added, it was quite likely that the mess would be resolved only by direct government intervention to support the banking system.

Which brings us back neatly to the Democrats gathering in Denver (as well as the Republicans meeting next week in St Paul, Minnesota). Both sides are whipping themselves into the usual frenzy of excitement that, very soon now, it will be their turn to run the country.

Yet with the health of the financial system at risk and the broader economy held hostage to it, it's starting to look as though the 2008 election might be a really good one to lose. Don't take it from me. Take it from one of the most prominent of the Democratic Party's economic and financial policy thinkers. Last weekend I heard Roger Altman, a senior Treasury official in the last Clinton administration, who now runs Evercore Partners, a private equity group, and would normally be considered a likely candidate for a top job in a future Obama administration. Speaking to an audience at the annual Vail Symposium high in the Rocky Mountains west of Denver, he offered a bleak assessment of the policy challenges for the next president.

“There are a number of jobs out there that many of you might think you'd like to have,” he said. “Being our 44th President is not one of them.”

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